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Our recognition and disclosure model reveals that price informativeness is determined by the interaction of the qualities of three information sources-the recognized amount, the disclosed information, and the information revealed by price-and accounting expertise acquisition. It also reveals that recognition of an accounting amount alters each of these, thereby affecting price informativeness. Perhaps surprisingly, we find that recognition of a highly unreliable accounting amount, rather than simply disclosing it, can result in greater price informativeness. Likewise, recognition of a highly reliable amount can result in lower price informativeness. Our findings suggest that, because of the effects of aggregation, basing recognition decisions on reliability alone is too simplistic. Reliability relative to relevance is key, not reliability per se. We also find that recognition and disclosure affect the coefficients in a regression of price on accounting amounts. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2003.

To restore investors' confidence in the reliability of corporate financial disclosures, the Sarbanes-Oxley Act of 2002 mandated stricter regulations and arguably increased auditors' liability. In this paper, we analyze the effects of increased auditor liability on the audit failure rate, the cost of capital, and the level of new investment. We focus on a setting in which, with imperfect auditing, a firm has better information than investors about its prospects and seeks to raise capital for new investments in a lemons market. The equilibrium analysis derives corporate reporting and investing choices by the firm, attestation opinions by the auditor, and valuation by rational investors. Three empirically testable predictions emerge: although increasing auditor liability decreases the audit failure rate and the cost of capital for new projects, it also decreases the level of new profitable investments. 1 We should note that SOX did not explicitly raise auditors' liability. However, early evidence suggests audit liability is higher after SOX. For example, Rashkover and Winter [2005] argue that civil monetary penalties have increased because SOX empowers federal courts and the SEC to impose equitable remedies for violations of federal securities laws. Ghosh and Pawlewicz [2008] document that audit fees after SOX are higher partially because of higher legal liability due to an audit failure. Also see the references cited therein. 2 asymmetry and the lemons premium. However, the auditor's attestation is imperfect; the auditor must make a judgment call based on limited information; therefore, the auditor's opinion is subject to unintentional errors. The auditor, after observing imperfect audit evidence, may unknowingly attest to financial statements that under-or over-value existing equity. An increase in the liability for audit failures may reduce the incentive for new profitable investments. Because the auditor's attestation is subject to possible audit failures, an increase in the liability for such audit failures induces the auditor to become more conservative in his interpretation of financial disclosures. As a result, the firm needs to choose its corporate disclosure strategy and investment decision based on its anticipation of both the investors' valuation and a possible audit failure. When a firm has private information about its existing equity, the chance of receiving understated financial statements increases. As long as the new shareholders cannot infer the true value from the understated reports, the lemons problem will depress the firm's valuation, thereby increasing the firm's cost of capital and making new investments less likely. In sum, our results identify an economic consequence of SOX the literature has not previously asserted: the increase in the auditor liability after SOX has the countervailing effects of decreasing both audit failures and new investments.Our study suggests several implications of SOX for investors, auditors, and policy makers. In the presence of information asymmetry between ...

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